Are Unrealized Capital Gains Income?

Recently a post from “Americans for Tax Fairness” made the rounds on Twitter, where they accused the super-rich of earning most of their income via “unrealized capital gains” and thereby escaping taxes:

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In response, many conservative and libertarian readers RT’d the post with incredulity, making various arguments as to why the proposal was absurd. In the comments under the original tweet itself, here is a good sampling of the pushback, and note that we didn’t splice these comments together; there was almost a uniform hostility along these lines:

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Beyond this outrage from the general Twitter audience, I saw PhDs (some in economics) flatly declaring that unrealized capital gains are not a form of income and that only a fool could argue otherwise.

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Now at this point, I was in a weird spot. I have written a dissertation on capital & interest theory, and study guides to several major works (one, two, and three) in the Austrian School tradition. Because of this background, I know that certainly for the Austrian giants, capital gains are a form of income (whether realized or not). Indeed, far from some hokey theory put forward by the tax grabbers, this is basic accounting, at least if we mean accrual accounting (which is required for large firms).

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On the other hand, I am both philosophically and pragmatically opposed to any government taxation of income, which certainly includes the taxation of unrealized capital gains. So I was in the awkward position of arguing that the premise of the “Americans for Tax Fairness” tweet was valid, but their conclusions were horrible. As so often happens on Twitter, my attempted nuance did not fare well.

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So let me take this opportunity to spell out why, in both economic theory and corporate accounting, an unrealized capital gain (at least under certain conditions) constitutes “income.” The purpose of this article is to convey what the point of accounting is; it’s not merely to tally up how much a business owes the IRS. As Mises demonstrated better than any other economist, the social purpose of accounting is to guide entrepreneurial action. As such, the people making business decisions need to have market feedback in “real-time,” and thus they need to know the profitability of various components of their enterprise sometimes years before cash comes in the door. There are two entirely different discussions about whether something is income versus whether it should be taxed.

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Relevance to Pending Supreme Court Case

This issue is of special significance to the friends of infineo because one of our main passions is to educate clients on the proper use of customized Whole Life insurance policies as cash management vehicles. An important element of this approach is to pledge the cash surrender value of your policy in order to receive a loan (on very favorable terms) to finance expenditures.

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Because of this connection, on infineo’s “infi” podcast I recently had Dean Emeritus of Columbia Law School, David Schizer, as a guest. The context of our discussion was the pending Moore case before the Supreme Court, which involved the constitutionality (or lack thereof) of taxing unrealized gains.

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To set the stage for our conversation, Schizer first explained that, as a general rule, the IRS currently does not tax capital gains until they’re realized. For example, if you buy a stock at $100 and next year it goes up to $150, if you still hold it, you don’t pay any income tax. It’s only when you sell and “realize” the gain, that you settle up with the IRS. Schizer and I talked about the various reasons for this procedure, including the fact that it makes the administrative burden easier and it smooths out the volatility of the ups and downs that might occur while you hold an asset.

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Yet because of this structure of the tax code, individuals—particularly if they are wealthy and deal in the financial sector—can structure their finances in a way to legally reduce their tax liability. For example, consider a founder who launches a company from his garage but decades later its market cap is in the billions. If the founder held on to his stock the entire time, he wouldn’t pay any capital gains tax.

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Now you might wonder how such a founder can eat. Does he need to pay himself a large salary? No, because then he’d have to pay income tax on it, just like other workers. Instead, he can go to a bank or other lender, pledge his stock as collateral, and take out a loan, in order to buy a mansion, yacht, private jet, etc. A loan isn’t net income—you are receiving cash, but simultaneously incurring a liability of the same dollar amount—and so that’s not taxable.

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You might think that eventually the founder dies and passes his stock on to his heirs, at which point the IRS would grab its share of the appreciation. But no, there is a “step-up in basis” rule, meaning that the “cost basis” of the shares the heirs inherit is the market price of the shares at the time of transference. This fact leads to what Schizer called the “hold, borrow, die” motto.

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Now that I’ve given more context behind the practices that the original tweet above had in mind, let’s proceed to the broader issue of whether capital gains should be considered as income. To repeat, I am not arguing that they should be taxed—this would be a bad idea both ethically and economically. But in terms of the underlying reality, it is undeniable that economics and standard corporate accounting recognize that capital gains are income just as surely as wages and dividends.

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First, an Appeal to Authority

In the following section, I will give some intuitive examples to motivate my position. But first, let me provide some evidence from other authorities.

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For example, in his masterpiece Human Action, Ludwig von Mises declares:

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The whole complex of goods destined for acquisition is evaluated in money terms, and this sum-the capital--is the starting point of economic calculation. The immediate end of acquisitive action is to increase or, at least, to preserve the capital. That amount which can be consumed within a definite period without lowering the capital is called income. If consumption exceeds the income available, the difference is called capital consumption. If the income available is greater than the amount consumed, the difference is called saving. Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption. [Scholar’s Edition, p. 261, bold added.]

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Mises’ formal definition of income—namely, the amount of consumption that can occur during a time period without reducing the market value of the capital—is standard in economics. Notice that with this definition, any capital gain, whether realized or not, would be classified as “income.” For example, if someone’s house during the course of a year went from $200,000 to $220,000, then the homeowner in principle could take out a $20,000 loan against the equity, in order to finance vacations and fancy dinners. The new liability of $20,000 would offset the increase in the value of the house so that the owner’s net worth was unaffected even though he’d enjoyed $20,000 worth of enjoyment during the year.

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Murray Rothbard in Man, Economy, and State likewise declares: “Are capital gains income? It seems evident that they are; indeed, capital gain is one of the leading forms of income.”

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Finally, investopedia informs us that when a firm holds securities for trading, then they “are recorded on the balance sheet at their fair [market] value, and the unrealized gains and losses are recorded on the income statement.”

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Indeed, step back and consider the three financial reports that large companies are required to periodically issue to shareholders: (1) an income (or P&L) statement, (2) a consolidated balance sheet, (3) a statement of cash flows. According to much of the Twitter outrage over the tweet showcased above, it would be nonsensical to have an income statement and a cash flow statement, since those (allegedly) are the same thing.

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But no, the point is that in terms of economic theory and (accrual) accounting, income and expenses do not necessarily line up with the influx and outflow of money. And as I’ll try to demonstrate in the next section, there are good reasons for this important distinction.

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Simple Examples

Consider a large grocery store with a high-class deli counter. Three guys each work a shift (they all have comparable experience and have the same job title) and walk up to the manager afterwards. Here is what he gives to each of them:

1. To the first guy, the manager gives $100 in actual currency.

2. The second guy says his wife wanted him to get meats and cheese anyway, so the manager lets him take $100 worth of merchandise without going through the intermediary step of handing him the cash and then taking it right back.

3. The third guy actually owed $100 from an advance on his pay that he had earlier taken, so the manager brings out the IOU and rips it up, saying the debt has been extinguished.

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As an economist, I am going to declare that all of the three men above earned an income of $100 by working the shift at the deli. Trying to say that only the first guy “really” earned income will tie us up into all kinds of knots, and also (for what it’s worth) would give a huge opportunity for businesses to pay their employees “in kind” to reduce tax liability.

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So we’ve seen that the receipt of cash is not necessary for income to have been earned. Now let’s go the other way and show it’s not sufficient either. Consider the following three scenarios:

1. A guy obtains $100 in extra cash by working a shift at the deli.

2. A guy obtains $100 in extra cash by doing a cash advance on his credit card at the ATM.

3. A guy obtains $100 in extra cash by selling 5 shares of stock he owns when the price per share is $20.

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As an economist, I am going to declare that in the above list, only the first option counts as an income of $100. The other two choices are not examples of an income being earned. My answer here, and above with the first three scenarios, are all consistent with Mises’ definition of “income,” and I leave it as an exercise for the reader to see why.

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Good Accounting Guides Action

Let me close by stressing that the “social function” of accounting is to guide entrepreneurial action. For example, take the case of a large investment bank that has several funds, such as a commodities fund, a fixed-income fund, a tech stock fund, a real estate fund, and so on. Now when the CEO and other corporate officials are reviewing their reports to see how the company is doing, it won’t do if each of the heads of the various funds says, “We can’t tell you whether we earned a profit this quarter, because we’re still holding on to the assets we originally bought a few years ago. Once we sell, we can tell you our gain or loss down to the penny. Thanks for checking in, boss!”

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On the contrary, the corporate accountants are going to keep very close tabs on the performance of each fund, by “marking to market” the assets (at least once a quarter) in order to determine what net income (or loss) each component of the overall corporation has yielded in the prior period.

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For a final example, consider a classic problem from the capital & interest literature: Suppose you own a forest and want to determine when to cut down the trees. When the trees are relatively young, you want to wait and let them develop, but on the other hand, you don’t want to let centuries go by before selling any timber. Pioneers in this literature like Eugen von Bohm-Bawerk and Irving Fisher showed that the profit-maximizing approach is to let the forest grow so long as the yield is appreciating at more than the market rate of interest, and to cut when the two rates are equal. (We can of course make the answer more sophisticated depending on anticipated changes in the spot price of lumber, etc.)

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But the important point for our purposes is that the owner of a forest needs to calculate whether his continued refusal to cut is profitable or not. That is, in an accounting sense the owner of the forest can determine if he had a profitable year or not, even in cases where he didn’t have any sales. This obviously only makes sense in a framework where “net income” refers to an increase in net market value, rather than “an influx of currency into the cash register.”

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In conclusion, I agree with the crowd on Twitter who were scandalized by the proposal to tax unrealized capital gains. This would be immoral, economically destructive, and possibly unconstitutional. But one thing I would not say in opposition to the proposal is that, “Unrealized capital gains aren’t really income.” Because according to both economic theory and corporate accounting, they are.

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NOTE: This article was released 24 hours earlier on the IBC Infinite Banking Users Group on Facebook.

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Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

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Twitter: @infineogroup, @BobMurphyEcon

Linkedin: infineo group, Robert Murphy

Youtube: infineo group

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To learn more about infineo, please visit the infineo website